Valuation gawking has become the official spectator sport of Silicon Valley. Nothing draws ooos and aahs from the crowd like a jumbo financing of a young company at valuations well into the billions. Then there is the inevitable Monday morning quarterbacking--"How could that company be worth blah blah blah? Certainly we must be in a big fat tech bubble. Those VCs are crazy, what could they be thinking?" Everyone wants to know: why are valuations so high right now? Will this lead to some horrible crash? Here is my take.
Considering that our economy was teetering at the edge of oblivion in 2008, we are back to the good times. Optimism is rampant in Silicon Valley, driven by the conviction that a fresh crop of big new companies will emerge from themes like Enterprise Saas/Cloud software, marketplace services like Uber and Airbnb, migration to mobile and wearable devices, and virtual reality just to name a few. Optimism always breeds investing activity, and right now everyone is seeing the glass not just half full, but overflowing with opportunity.
Supply and Demand and a Pinch of Ego
Tech companies traditionally had to IPO in order to raise $50 to $100 million of growth capital. It has long been a right of passage and had the bonus of liquidity for employees and investors. Unfortunately it also included the not-so-fun regulatory burden and brutal short-term focus of public markets. But in the last five years venture growth capital has exploded, offering young companies the ability raise very large growth rounds while staying private. This is great for the company, but not-so-much for public investors who love the dramatic growth and gains that tech companies provide. Facebook is a great example of a company that grew to $100 billion valuation while private, keeping all of that gain in the hands of a precious few.
As a result, returns-hungry institutional investors have turned to late stage venture to try and grab their piece of the pie. Companies like Fidelity have created late stage venture funds and have flooded the market with capital. Now there is more money competing for the few great investments and that drives valuations up.
For entrepreneurs with companies in hot categories it's a bonanza. They can build a huge war chest for very little dilution and perhaps enjoy the ego boost of joining the coveted billion-dollar club, (while turning a cheek to the potential future disaster that might be created by getting way ahead of their skis on valuation). And they are taking full advantage.
Excuse Me, Where is the IPO Party?
Oddly missing from this party is the IPO market, which has recently been very cool to emerging tech companies. It has become clear there is little appetite for paying jumbo prices for the new bunch of billion dollar babies. Simply stated, public investors think these companies are being over valued by late stage VCs. Many companies have had to delay planned IPOs. Some like Box, Inc. were able to go public, but at a lower valuation then their last VC round. This may sound like bad news for those late stage VCs, but it has become common for them to add protective features like "ratchets" that effectively adjust their ownership to compensate for a "down-round" IPO. Good for them, but very costly to founders, employees and early investors.
The Tech Bulge
Interestingly, this situation is a monumental reversal of sentiment. In the past, VCs have been conservative when valuing companies while the public markets have traded on irrational exuberance. That's why there is virtually no risk of a tech bubble like 2002; the public markets are essentially sitting on the sidelines. This has led to an entirely new phenomenon: The tech bulge.
Historically, this should be a brisk time for new tech IPOs. The stock market is on a bull run. There is no shortage of exciting companies that are operating at scale. In fact, the biotech sector is experiencing quite the IPO boom. But scant few tech companies are making it through. As a result, there is a growing reservoir, a whopping 200 at last count, of private companies whose valuations exceed $1 billion, causing a huge bulge at the entrance to the IPO funnel. At some point these companies will need to get public or be acquired--and there will be a day of reckoning over their valuations.
There is no precedent for the Tech Bulge. We are truly in uncharted waters and despite all of the current optimism, there is growing sense of tension in the VC community.
But hey, it's not all bad.
The good news is that entrepreneurs can now grow their companies to real scale, while maintaining the simplicity and focus of being private. The theory is that they will become mature enough to have the predictability required to be a successful public company and someday be valued in the tens of billions. This should be a win-win. But for now, Wall Street is not buying Sand Hill Road's theory and something's got to give. Either the IPO market comes to appreciate the true worth of the billion dollar club and pays the price, or late stage VCs will be forced to adjust their thinking. In that case it won't be a big crash, but more like a financial breaking of wind. The pressure will be relieved-;you just won't want to be in the area.
We often confuse a company's value with its worth. When a company raises $100 million at a $1 billion valuation it simply means in that moment in time, someone was willing to buy some of the company at that price. What that company is actually worth is something that will be tested over a period of years and with the inevitable challenges that come in a free market economy.